Investment Outlook for 2010

Wednesday, 06 January 2010 13:53

Written by Roger Camrass

A sex worker once commented that the most interesting part of her job was knocking on the hotel doors of new ‘clients’. In her view the sense of uncertainty as to what lay on the other side helped to offset the monotony of an otherwise routine occupation. This observation surely has resonance for many private investors as they look towards 2010 and beyond. After so many surprises (good and bad) in 2007-9, what lies behind the door of the new decade?

In this report we examine the macro trends that provide the foundations for an investment strategy for 2010 and the coming decade. We look at historic trends over the last decade and question how different the future might be. We also consider downside risks and conclude with an investment strategy and asset allocation for the 2010. An Appendix covers countries and individual asset classes in more detail.

Macro Investment Trends for 2010 and the coming decade

Here are some core trends and assumptions that should govern private investment strategy over the next five to ten years:

The exceptional Bull market of the nineties has given way to a sideways shift over the last decade. We can expect another Bull market but this could take some years to materialize given the current economic and political uncertainties. The implication is to remain cautious but prepare for an eventual up turn (2012?).
Asian Markets (with the exception of Japan) and Latin America will continue their rapid GDP growth rates (some 6% average). Buoyed by political stability in India and China, and strong national balance sheets, they will remain the engines of global economic growth across the Globe. The ‘E7’ will outstrip the ‘G7’ during the next decade as investment opportunities.
Western economies will recover more slowly (around 2.5%), but the USA could lead the way – first into recession and first to emerge from it. Despite recent trends, the dollar could strengthen and as a consequence slow or halt the rise in Gold prices. Europe will have a mixed record with France and Germany the clear leaders but the UK a likely laggard due to public indebtedness.
Defensive stocks (e.g. Pharma, Oil and utilities) and income funds will be wise choices as we step cautiously towards a bull market in the next 2-3 years. They will provide an attractive income alternative to cash in a low interest rate environment (up to 2011). However there will be scope for some upside with an expected bounce back in finance, industrial and high tech sectors.
Commodities will continue their upward trend as developing countries enjoy a higher standard of living and lay the foundations of a modern society – with emphasis on infrastructure (road, rail, air, etc). Oil should rise above $100 per barrel in 2010. Property should gradually regain value as housing stock dries up and sources of funds become more abundant (at historically low interest rates).

Overall we anticipate double digit growth for a well diversified investment portfolio over the next year (target of 12% compared to 22% in 2009). This should be sustained in 2011 and beyond, barring any further global crises (e.g. political such as Iran). Portfolios should return to their pre-2008 levels in the coming year and begin to grow in absolute terms thereafter.

Lessons from recent decades

A quick look at the FTSE 100 Index over the last twenty five years may offer a glimpse ahead. The UK market (as with other G7 economies) maintained steady growth over the first fifteen years (1985-1999) fuelled by global economic performance. Thereafter a combination of consumer and public overspending, dot.com bust, 7/11, war in Iraq and sub-prime mortgage crisis has knocked the wind out of its sails. Both the FTSE and S&P are well below 1999 levels (by 21 and 24% respectively).

History would suggest that the next decade should offer more positive growth prospects. But there have been similar periods of sideways movement in recent history (the twenties and sixties) when a ten year Bull was followed by a 12-15 year period of sideways movement.

FTSE 100 : historic trends

ftse 100 historic trends

The possibility of further ‘sideways’ movements suggested a cautious return to equities in the G7 economies (perhaps through defensive stocks and income based funds).

Similar effects have been observed in the emerging (E7) stock market exchanges – but at a much more compressed rate. The Shanghai Composite is up 140% over the decade and the Indian Sensex up 249% thanks to success in the IT off-shoring sector.

Shanghai Composite: 2005-2009

shanghai composite 2005-2009

The implications of all these trends for investors is a period of caution whilst the market prepares for another ten year Bull cycle (2012 or beyond).

Did 2009 represent a turning point?

An optimist must believe that 2009 presents us with a possible conclusion to one of the worst periods of financial turmoil that the world has seen in 70 years. Governments, corporates and individuals all fought to keep their head above water during the year and were rewarded by sustained economic bounce back in most parts of the world from April onwards. Despite the partial recovery however we end 2009 at a ten year low – opening up some fundamental questions about what comes next.

With the exception of Brazil (now top of its game) the main stock markets are still well below their peaks of 2000 and 2007/8. For example the Shanghai Composite reached 6,000 in 2007 but is at a mere 3,300 today despite outstanding performance over the year. What we have seen during the last decade is a significant decline in equities against all other investment instruments (even cash).

Equity Markets	Decline in 2008	Growth in 2009	Relative to Jan08
	(Jan to Dec 08)	(Jan to Dec 09)	(Dec 09 ^Jan08)
Shanghai Composite	-65%	+79%	-32%
Indian BSE Sensex	-51%	+81%	-12%
Brazil IBOVESPA	-38%	+84%	+14%
S&P 500	-34%	+24%	-18%
Dax	-37%	-37%	-31%
CAC	-41%	+22%	-30%
FTSE100	-29%	+22%	-29%
FTSE250	-37%	+47%	-10%

Succeeding in a ‘lost decade’

The so-called ‘lost decade’ of 2000 to 2009 is counter to historic trends and suggests that valuations were artificially high in 1999. According to the Tobin Q Index the markets stood at nearly 2.0 – double the realistic value of the time. Today the Tobin Index is 0.5 suggesting an equally unrealistic situation. Based on this observation, we can expect markets to re-establish themselves over the next 5-10 years and to produce double digit returns (as has been the case this year with a 22% rise).

The key factor for successful investment strategies over this ‘lost decade’ has been diversification.

A portfolio containing exposure to international equity markets (USA, Europe and BRIC economies) as well as property, commodities and bonds has produced very acceptable returns over the decade (totaling 50-100%) compared to a pure equity play (with a 20% plus decline in the FTSE100 and S&P Indices). For example, an investment in natural resource funds would have produced a return of over 300% (e.g. Black Rock Gold and General, and JPM Natural Resources). Latin America also performed extremely well - 277% over five years. Returns over the decade have been remarkably strong in Gold (323%); Oil (214%); property (109%); cash (21%) – all post inflation.

The philosophy of a well diversified portfolio – both geographic and by asset class remains equally true for the coming years. However the asset mix should be different.

2010 - End of a bear cycle?

Casting aside a feeling of personal and collective relief at year end, what did we learn from 2009 that will prepare us for the year (and decade) ahead? There were some remarkable successes and failures during the year, for example:

Best Sectors: Global Emerging Markets (54%); UK Small Companies (50%) and Technology/Telecom (47%)
Best Markets: Brazil (96%); China and India (80%); Russia (121%) and overall Latin America region (77%)
Worst Sectors: UK Commercial Property (-44%), UK Gilts (-1.5%) and Money Markets (1%)

This must be set against a collective loss in equities of 30% in 2008 made worse in the UK by a ‘double whammy’ of equities losses (33%) plus Sterling depreciation bringing real loss to around 50% compared to other markets.

Markets hit rock bottom in March of 2009 only to go through a ‘dead cat bounce’ in April (3,700 in UK to 4,100 then back to 3,900). Thereafter the G20 agreed a £1.1 Trillion rescue package that has provided the necessary liquidity to encourage investors to return to the equity markets. For those who decided to hang on to their diminished portfolios the subsequent 50% rally as been a welcome relief. The nine month recovery period post April followed a two leg journey – release from the prospect of a genuine global depression (through injection of liquidity) followed by some reassuring economic and corporate news.

Despite this recovery, 2009 will be remembered as the worst time since second world war and great depression with 4.7% slump in UK GDP; global economic down of 1.1%; and slump in world trade down of 12%. In the UK alone, government pumped £63 Billion into RBS and Lloyds; and provided an additional £240 Billion of insurance against toxic debt. China and the USA invested well over a trillion dollars each to help head off catastrophe. These extreme measures have tempted investors back into the equities and promoted a temporary boom market from April to December. Asian markets are up some 75% over the year, with Europe and the US averaging 25%. China has eased Japan out to become the second largest economy in the world.

A new stabilizing factor for 2010 – reduction in debt

Many of the world’s financial problems have arisen from over indebtedness at a national, corporate and personal level. Can we assume that this situation is now behind us? Many Western governments enter 2010 in a much more perilous state than 2008 or 2009. Massive state intervention has come at a high price. Sovereign debt crises could be the biggest issue for the next decade – extending from the third world into Europe (e.g. Greece, Ireland and possibly the UK).

Although housing prices are stabilizing in the USA (up slightly for the last five months) and UK (rising 7% this year after a 20% fall back in 2008), they have produced hundreds of billions of dollars of negative equity that could still disrupt the banking system and curb consumer spending. Despite this, consumers in the UK continue to enjoy the good life with 30 Million people yet to pay off Christmas debts on 2008 expenditures!

Corporations have been more sparing as they faced near Armageddon situations earlier in the year. With the prospect of a gaping hole in debt re-financing (remember that banks almost ceased to lend any money over the first quarter), most companies have reduced inventories, cut back heavily on CAPEX spend and subjected workers to near pay freeze conditions – far detached from the largesse of the public and banking sectors who are enjoying record bonuses and salary rises this year.

What else might go wrong?

We have already mentioned indebtedness at every level – especially Government (such as the UK) and personal (mortgages and credit cards). Here are some further areas of concern that could impede or derail economic growth at least for the next two years:

Political risk – the blatant efforts of Iran to draw the world into armed conflict could well take an ugly course next year as it approaches full nuclear capability (something that Israel and the West cannot afford to live with). Terrorism will continue to be a threat to all western countries as Islamism gains currency.
Economic risks – the premature withdrawal of the generous, Trillion dollar plus economic stimulus packages (and quantitative easing measures) could reduce investor confidence for a second time, inducing a double dip in the markets. A Labour victory in the UK or hung parliament could have drastic local effects.
Inflationary spiral – signs of inflation might encourage central banks to raise interest rates from near zero levels (in USA and UK). This would put pressure on the private sector and reduce returns on equities. It would also make public sector borrowing more expensive and increase the tax burden yet again.

Taken in the round, these risks suggest a cautionary note for 2010. The rate at which governments withdraw quantitative easing; inflation starts to rise; central banks increase interest rates and property prices begin to recover will all influence the markets.

2010 investment strategy

Set against a prospective Bull cycle (maybe two to three years away) and the need to recover ground from the devastation of the last 2-3 years, investors will need to balance caution with optimism to rebuild and strengthen their portfolios.

Caution suggests the following near term approaches to protect portfolio value:

Pursue defensive stocks to generate income and protect current values (for example, BP and Shell; National Grid and United Utilities; GSK and Astra Zeneca in the UK).
Seek ‘Value based’ stocks with real assets (hedge against inflation) – following Buffett’s recent example with Santa Fe Railroads. These are likely to include infrastructure firms such as Balfour Beatty in the UK as well as outsourcing firms.
Back large global firms rather than small local businesses to ensure maximum exposure to growth regions (E7). For example, many of the Dow 30 corporates that have global operations – industrials, chemicals, etc.
Continue to maintain a diverse portfolio in geographic (East versus West) and asset terms (commodities; property; energy). Avoid investment in local markets and businesses (keep UK down to 10% of overall portfolio)

Prospect of a new Bull market cycle suggests additional measures to expand portfolio value:

Expand exposure to E7 region – BRIC economies and other high growth countries. This may be best achieved through BRIC, Emerging Market and Global funds that have performed extremely well in recent months and years.
Back potential growth sectors such as High Tech and Healthcare that could beat the market averages. Developments in cloud computing, m-commerce, eco-systems and other innovative segments are worth a punt.
Invest in ‘bounce back’ sectors that have suffered unduly in recent years, Financials and commercial property are the classics here, but other sectors have performed badly such as Pharma and Utilities.

A DPF version of this report is available here Investment_Outlook_for_2010.pdf, including the detailed Appendix (16 pages)

Roger Camrass is a veteran of the Silicon revolution and a change junkie of global proportion. He was part of the Internet design team at MIT in the seventies and surfed through decades of entrepreneurial and consulting activity to reach the dot.com boom and bust at Ernst & Young as a Partner in 2000. More recently he has led business transformation at Fujitsu (Japan) and now at Wipro (India) – developing a personal context for ‘East meets West’. He spends he spare time nursing his meagre investment portfolio by devouring acres of financial journalism.

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